Did you know that 58% of small business owners do not have a business succession plan and almost half believe they do not need one? Yet, despite the lack of prevalence, a succession plan is a foundational component for any business. The belief that your organization does not need a succession plan often stems from misconceptions around what a business succession plan looks like and what it should accomplish.
Many people think that a succession plan is a simple exit strategy document – something you put together when the owner wants to retire. As a result, companies with young, passionate, highly engaged owners often do not see the need to put one together.
Other times, business owners assume a succession plan would only be necessary if there was a catastrophic event. In this scenario, it becomes incredibly easy to put off formalizing a plan amidst the hustle and bustle of daily business demands.
However, a business transition can occur for any reason – such as retirement, M&A interest, or a changing industry landscape. In each of these scenarios, a succession plan spells out the details of selling a business to achieve maximum value for both the buyer and the seller.
A business transition plan prepares the business for both unexpected events (like incapacitation or death) and the inevitable (retirement). In doing so, your succession plan should accomplish the following goals:
- Maintain your lifestyle into retirement
- Provide financial security for your family
- Protect the legacy you have built
- Preserve cash flow to continue to build value in the business
- Maintain continuity for your customers
- Minimize state and capital gains taxes
What is Included in a Succession Plan?
An effective succession plan will establish a timeline for transferring ownership and an explanation of how the business transition will occur. Information on funding sources should also be stipulated when a seller financing plan will be used.
Critically, it must also provide a current and correct business valuation. The valuation cannot be outdated given current business operations and market conditions, or an estimate based on what the owners think the business is worth. Ideally, this valuation should be generated by a reputable third-party to achieve unbiased impartiality.
Formal business documents are typically included in a succession plan as well. Standard operating procedures (SOPs) like employee handbooks, training documents, business processes, current contracts, and formalized internal procedures are handed over to facilitate a smooth transition of ownership and ensure the continued success of the business.
When transferring ownership instead of liquidating the business, your exit strategy options include:
Passing the Business on to an Heir
While many business owners want to pass their company on to an heir to keep it in the family, this is not always the best solution. Choosing among multiple heirs or splitting it among all of them is complicated and can create tense family relations. The transition can be chaotic and stressful if family politics muddle the sale. And while there may be a willingness to take over the business, an heir may not have the skills or qualifications needed to take over. For this reason only 30% of inherited businesses make it after they have been passed down to a second-generation.
Selling to a Co-Owner or Key Employee
Selling the business to a co-owner or key employee is a logical choice because they are already familiar with the business and have proved their merits at the company. As a result, either one is likely more qualified to run the business than an heir. Additionally, a co-owner taking over full ownership is an expected next step when the other business owner leaves.
Unfortunately, it requires significant cash on hand to buy out a co-owner or purchase the business from the owner. Fortunately, that is why agreements like seller financing plans exist to spread out the cost of buying the business. A broker or M&A expert can find a flexible financing option that is advantageous to both the buyer and seller.
Selling to a Third Party
Selling the business to an outside entrepreneur, competitor, or other third-party creates a much wider buyer pool. It is, however, often more complicated because it hinges heavily on the business valuation. You will need to take additional steps to prepare the company for sale when selling externally which takes longer and involves more work. A third-party sale is also less predictable because any number of roadblocks can arise. A business broker can manage this process for you to ensure everything is handled correctly and you are getting the best price for your company.
Selling Your Ownership Stake Back to The Company
Selling your ownership stake back to the company allows you to distribute its value among the remaining owners. This strategy keeps the people who are already invested in the business and familiar with its day-to-day operations in charge. However, it is also more complicated to execute on the sell side and can result in higher capital gains taxes on the buy side depending on the specifics of the sale.
Avoiding Common Mistakes
Regardless of how you plan to transfer ownership, follow these best practices to avoid common exit strategy mistakes:
While 3-5 years of planning is typical, it is never too early to start thinking about how you will leave the business eventually. If you try to get out of the business too quickly, you may not receive the full value of the business. Even six months or a year can make all the difference when planning for a business transition.
Choose the Right Successor
Ensure that whoever the business is being sold to wants to own it. This may sound like obvious advice, but it is especially crucial in the case of an heir because a reluctant owner will not be an effective leader.
Do not let emotions take over during the valuation. Remember, much of a company’s value is in its intangibles rather than its hard assets. However, many business owners assume their business is worth more than it really is because they are so emotionally invested it. This connection makes it extremely difficult to remain objective, but objectivity is crucial throughout the succession planning process.
Keep the Succession Plan Current
Both internal and external shifts can change succession plans significantly. Review and update your plan regularly, especially when changes occur, to keep it current and relevant.
Consider the Bigger Picture
Plan for the bigger picture. While sale price is certainly important, minimizing tax costs, utilizing asset protected structures, maintaining cash flow, and protecting wealth should also be taken into consideration.
As you create your succession plan your advisors should be a part of the team. Be sure to include your CPA, attorney, and investment banker in addition to your executive team. CFO Selections provides both fractional and project-focused CFOs and controllers should the need arise. Our cash flow calculator can also aid in your day-to-day operations as well as your business valuation.